In financial markets an excess of buying tends to drive prices up, and an excess of selling tends to drive them down. This is called market impact. Based on a simplified model for market making, it is possible to derive a unique functional form for market impact. This can be used to formulate a nonequilibrium theory for price formation. Commonly used trading strategies such as value investing and trend following induce characteristic dynamics in the price. Although there is a tendency for self-fulfilling prophesies, this is not always the case; in particular, many value investing strategies fail to make prices reflect values. When there is a diversity of preceived values, nonlinear strategies give rise to excess volatility. Many market phenomena such as trends and temporal correlations in volume and volatility have simple explanations. The theory is both simple and experimentally testable.
Under this theory there is an emphasis on the interrelationships of strategies that makes it natural to regard a market as a financial ecology. A variety of examples show how diversity emerges autmatically as new stategies exploit the inefficiencies of old strategies. This results in capital reallocations that evolve on longer timescales, and cause apparent nonstationarities on shorter timescales. The drive toward market efficiency can be studied in the dynamical context of pattern evolution. The evolution of the capital of a strategy is analogous to the evolution of the population of a biolgoical species. Several different arguments suggest that the timescale for market efficiency is years to decades.
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Paper provided by Santa Fe Institute in its series Research in Economics with number
98-12-117e.
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